Most corporate ARS investors revealed the accounting change in their first-quarter regulatory filings. Many companies also noted that the adjustments were immaterial and therefore have no adverse affect on the company’s financial performance. Some experts say, however, that the impact of the reclassification may have hidden consequences that CFOs have yet to discover, including market-liquidity problems and debt covenant-defaults.
Ordinarily, a change that doesn’t alter a company’s total assets and is little more than a debt-and-credit balancing exercise wouldn’t attract much attention. But the accounting turnabout is also the latest of a number of problems plaguing the 21-year-old ARS market. Not the least of them is the fallout from the ongoing SEC investigation.
Currently, most auctions are run by a single dealer, and seven of the main securities firms that run them have been contacted by the SEC regarding its investigation. When too few bids come in, the dealer typically props up the auction by entering into the process and placing the final, or “clearing,” bid.
The practice of dealer intervention is at the crux of the SEC probe. Although the commission declined to comment on the investigation, people in the market think that investigators are examining dealer practices. By propping up the auction, the dealer winds up on both sides of the transaction, running the auction for the benefit of issuer and setting the price of the bond for the investor, says CAG’s Pan. If that’s perceived as a conflict of interest, regulatory reform could be in the offing.
Indeed, investors and regulators are worry that many auction-rate issues are handled by only one dealer, notes SVB’s Anderson. “Suppose the dealer decides to stop supporting the market,” he says. “The amount of control one firm has over the auctions, the issuers, and the investors is the reason the SEC is investigating the market.”
Regardless of whether the commission orders a market makeover, however, SVB’s Anderson asserts that liquidity issues are surfacing. Based on the huge spreads — between 40 and 50 basis points — that followed the accounting change, he deduces that the demand for the securities declined.
A drop in demand can’t be verified quantitatively because the dealers that run auctions don’t reveal final bid-to-cover ratios (a measure of auction-demand volume), he says. “No one knows how successful the auctions actually are,” adds Anderson. “We know demand is going down because spreads are going up.”
There’s no doubt that the appetite for new issues has slowed. Between 2001 and 2003, the number of new auction-rate bond issues doubled each year, with 425 new issues generating $43.5 billion in proceeds in 2003, according to Thomson Financial. But in 2004, only 431 new bonds raising $44 billion were issued, a measly increase compared with the 100 percent hikes recorded in previous years. So far this year, 73 new issues have been sent to auctions, generating $7 billion.
A pull-out by too many buyers would lead to a drastic supply-and-demand imbalance. In the extreme, it could spawn failed auctions, which are technically defined as ones lacking the demand needed to sell an entire block of bonds. In that case, treasury managers would have no way of cashing in their long-term bonds except at deep discounts. In effect, buyers would be stuck holding 30-year bonds, not the short-term debt they’d sought.